Research Seminar - Christopher Gibbs (University of Sydney) - Optimal Monetary Policy when Expectations are Rational, Fixed, Learned, or Anything in Between


There is broad agreement that expectations play a central role in the transmission of monetary policy to real economic activity. There is far less agreement, however, in how people form expectations. We revisit optimal monetary policy design in a model where expectations are formed using a mix of rational and adaptive learning beliefs. The beliefs approximate several alternative models of expectation formation - fixed, learning, myopic, level-k, and rational - using only two parameters. We derive the optimal targeting criterion in the model as a function of these parameters, i.e., in terms of how beliefs are formed. A weighted average inflation target plus adjustments for belief persistence and the zero lower bound characterize optimal policy. Our target criterion provides a theoretical justification for Flexible Average Inflation Targeting, where we make explicit what average and flexible should mean.


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